Tag Archives: digest

The following is a digest of posts from Guy Thomas’s Free Capital blog from Feb 2011 through Jan 2012. Each post provides a link to the parent article with bullet-pointed lists of key-takeaways from each. For the complete discussion by the original author, please click the link to the parent article.

Diamonds are companies with exceptional economics and long-term competitive advantages that you’d be happy to hold if the stock exchange closed tomorrow for the next five years

Flower bulbs are companies which are cheap at the moment but which have no exceptional business qualities (they often make a good quantitative showing but not a strong qualitative one); they can usually be counted on to bloom but should be bought in modest size because they require liquidity to get back out of the position and realize the value

Which should you buy? Diamonds are exceptionally rare and require outstanding foresight of long-term durability; flower bulbs are more common, simpler to spot and merely require patience and a strong stomach

“Investing is a field where knowing your limitations is more important than stretching to surpass them”

How many shares should an investor hold? Some theory…

The optimal number of stocks to hold, N, is a function of…

quality of knowledge about return dispersions (decreasing)

$ size of portfolio (increasing)

volatility of shares (increasing)

capital gains tax rate (decreasing)

Exceptional investors with exceptional quality of knowledge should hold a concentrated portfolio; Buffett from 1977-2000 appears to have held approx. 1/3 of his portfolio in his best idea and changed it annually

With a small portfolio, liquidity is not a concern but as your portfolio scales a large number of holdings becomes optimal to maintain your liquidity which enhances your optionality by giving you the opportunity to change your mind without being trapped in a position

If the companies you target have highly volatile share prices, it becomes attractive to switch frequently so that you can “buy low and sell high”, thus you want to restrict your position sizing (higher number of positions) and maintain liquidity

If the capital gains rate is high you are penalized for turnover so you want to keep your total number of positions low and hold them for longer

How many shares should an investor hold? Some practicalities

There is clearly a trade-off between the number of positions you have and your quality of knowledge

A portfolio which is higher in diversification may hold many lower quality businesses (flower bulbs) but the certainty of the analysis of each might be significantly higher than a concentrated portfolio of several high quality businesses (diamonds) whose analysis is extremely sensitive to long-term forecasting accuracy

Concentrated investors often “come a cropper”

Many investors eventually disappoint because they have concentrated their bets on companies the world turns against

This has happened even to great investors like Warren Buffett (ex., WaPo, which now looks like a horse-and-buggy investment)

The danger of concentration is that nothing grows forever, and concentration + illiquidity often make it hard to escape mistakes

A good buying opportunity shouts at you from the market; if you need a calculator, let alone a spreadsheet, it’s probably too close

Robustness is more important than refinement; it’s easy to find apparent discrepancies in valuation, but most are false– it’s more important to seek out independent insights which confirm or deny the discrepancy than to calculate its size; when info quality is good, focus on quantifying and ranking options, but when it is poor, focus on raising it

Non-financial heuristics are often quicker and sufficiently accurate to lead to correct decisions; you may make more errors than the rigorous analyst but you can work much faster and evaluate many more opportunities which is usually a good trade-off

The “Geoff Gannon Digest” is a series of posts highlighting some of my favorite wit, wisdom and investment advice from value investor Geoff Gannon. Each post provides a link to the parent article with bullet-pointed lists of key-takeaways from each. For the complete discussion by the original author, please click the link to the parent article.

The “Geoff Gannon Digest” is a series of posts highlighting some of my favorite wit, wisdom and investment advice from value investor Geoff Gannon. Each post provides a link to the parent article with bullet-pointed lists of key-takeaways from each. For the complete discussion by the original author, please click the link to the parent article.

Grab 15 years of data from EDGAR and compare receivables, inventory, PP&E, accounts payable and accrued expenses to sales, EBITDA, etc.; E.g., if receivables rise faster than sales, this is where “reinvestment” is going

For a quick comparison, look at:

Net income

FCF

Buybacks + dividends

Compare debt (total liabilities) between the start of the period and the end and subtract the difference to get growth in debt

Then, sum all dividends and buybacks over the period, and all net income over the period

Then, subtract the change in debt from dividends/buybacks; what is left is dividends/buybacks generated by the business, rather than growth in debt

Then, compare this to net income to see the ratio of earnings paid out to shareholders

You can compare the growth in net income to retained earnings to get your average return on retained earnings

Look at the change in net income and sales over 10 years and then the ratio of cumulative buybacks and dividends to cumulative reported earnings

You’re looking for the central tendency of return on retained earnings, whether it is approx:

5%, bad business

15%, good business

30%, great business

Companies with single products easily generate high returns on retained earnings, but struggle to expand indefinitely

A company’s shareholder base changes as the business itself changes; for example, a bankruptcy turns creditors into shareholders

Shareholders often become “lost” over the years, forgetting they own a company and therefore forgetting to trade it

Some companies go public as a PR ploy, so investors may be sleepy and inactive

Buffett understood this and understood that a stock could be a bargain even at 300% of its last trade price– National American Fire Insurance (NAFI) example

Buying a spin-off makes sense because many of the shareholders are stuck with a stock they never wanted

An interesting screen: oldest public companies with the lowest floats (in terms of shares outstanding); a lack of stock splits combined with high insider ownership is a recipe for disinterest in pleasing Wall St

Once you know this, if you just try to buy one stock a year, the best you can find, and then forget you own it for the next 3 years, you’ll do fine; over-activity is a major problem for most investors

Bubble thinking requires higher math, emotional intelligence, etc.; that’s why a young child with basic arithmetic would make a great value investor because they’d only understand a stock as a piece of a business and only be able to do the math from the SEC filings

There are always so many things that everyone is trying to figure out; in reality, there are so few things that matter to any one specific company

One key to successful investing: minimizing buy and sell decisions; it’s hard to screw up by holding something too long

Look for the most obvious opportunities: it’s hard to pass on a profitable business selling for less than its cash

Extreme concentration works, you can make a lot of money:

waiting for the buyout

having more than 25% of your portfolio in a stock when the buyout comes

David Merkel, author of the AlephBlog, has an extensive background on Wall Street and is something of a value investor when it comes to his money management principles. There is a lot of good content on his site in various disciplines within the investment analysis and money management domains so this will likely be the beginning of a multi-part digest series. This one deals with his lessons about the corporate bond market. To read the entire original discussion, please click the title heading of each section.

be honest, keep your word on trades, don’t weasel out once you say “done”

have a fair reputation, that you don’t try to pull fast ones on the broker community

reputation for fairness should be reinforced by other actions

if ibank quotes price/spread out of market context, let them know what you know; only trade against them if they insist they’re right

if risk control desk comes to you with a trade to cover a short and you own the bonds, help them; make them pay a little more than the ask but don’t gouge, then they might offer you the long cross-hedge bond at a nice price

have an “openness policy”; reveal 80% and conceal 20%, the most critical 20%

your broker at the ibank is proud of his best clients; he doesn’t want to lose you if you’re bright, trade a lot, run a big account

never tell your whole story to any broker; break up your business among many brokers, with no overlap

it’s good to have a reputation for being bright, or at least not a pushover

It’s freeing to not think about whether a particular trade will generate a gain or a loss but rather how the portfolio can be improved

On price discovery in dealer markets, and auctions gone wrong. I never knew that I could haggle so well.

There may be 7000 actively traded stocks in the US but there are nearly 1,000,000 bonds, the last trade of which may have been a week or a month ago

After adjusting for default risk, the number one predictor of portfolio return is yield

Default risks are lower after the bust phase of the credit cycle, rise as the credit cycle gets long in the tooth

David does a trade: “But how to come to the right price/yield/spread? I had a few trades, but they were dated. I knew the spreads then, and used the spreads of more liquid similar credits to adjust it to a likely yield spread today. I put in a fudge factor because illiquid bonds are higher beta, and then studied which of my brokers might have a bead on the bonds in question. I would ask them their opinion, and if they were in my ballpark, I would back up my bid some, and bid for $1 or $2 million of the bonds. The response would come back, and I would have a trade, or nothing, but maybe some color on where they would be willing to sell. If a trade, I would back up my bid a little more, and offer to buy more. If no trade, I would offer 50-70% of the distance between our bid/offer, and see what they would do.”

On bond technical analysis, and how to deal with a rapidly growing client. Also, the end of my time as a bond manager, and the parties that came as a result. Oh, and putting your subordinates first.

On timing purchases and sales:

the large brokers generally know who is doing what

be nice to sales coverage, you’d be amazed what they’ll tell you

keeping the VIX on screen helped accelerate or slow down purchases and sales in a given day; yield spreads lag behind option volatility

On time horizons:

Three horizons

daily

weekly-monthly

credit cycle

On scaling:

moving in and out of positions slowly, as market conditions warranted, is useful

“Never demand liquidity unless it is an emergency and you meet the strenuous test that you know something everyone else does not. But, make others pay up for liquidity where possible. You are doing them a service.”

The “Geoff Gannon Digest” is a series of posts highlighting some of my favorite wit, wisdom and investment advice from value investor Geoff Gannon. Each post provides a link to the parent article with bullet-pointed lists of key-takeaways from each. For the complete discussion by the original author, please click the link to the parent article.

You can get a hint where a company is tripping up in delivering cash to shareholders (FCF) when:

EBITDA is positive

CFO is positive

Net income is positive

EBITDA measures the capitalization independent cash flow of the business; it doesn’t take into account spending today for benefits that won’t be realized until tomorrow; also misses working capital changes

Look for companies that are growing quickly in an industry that is not

Avoid companies that are fast growing in a fast growing industry; it will face more competition every year

To judge the future ROI of FCF reinvestment with a company that has no FCF, look at:

Will they be competitive?

Will competitors over expand?

Do they have a moat?

When a company spends so much on growth for so long, you really are betting on what the ROI will be way out in the future

“There isn’t necessarily a prize for being the last one to succumb to the inevitable. It’s usually more of a moral victory than an economic one”

Don’t short a great brand; if you want to short something, short a company:

with a product with inherently poor economics

a bad balance sheet

with deteriorating competitiveness

preferably in an industry with a high morality rate

When a company reinvests everything, you need to worry about what they’ll earn on their capital many years out

Disclaimer/Disclosure

No commentary on this site should be considered as an offer to buy or sell any security. No commentary on this site should be construed as investment advice or an offer to provide investment advice. I may or may not be an investor (long or short) in any of the securities I discuss.